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China banks to benefit from debt to equity swaps

China banks should benefit from the Chinese government's clean up of banks with debt to equity (D/E) swaps, Natixis Research reports. The D/E swaps help banks offload stressed assets to the rest of the financial sector or to financial investors at a very low cost.

Here's more from Natixis:

Chinese banks seem to have made meaningful progress in the resolution of problem loans. The aggregate amount of the announced debt-to-equity (D/E) swaps has reached 1,048 RMB billion, which amounted to 1.1% of total loans in end 2017. We expect banks to see an improvement in the overall asset quality with a corresponding relief on profitability, but only if the announced deals are implemented for real. In fact, only 15.7% of the total announced D/E swaps are actually happening. We believe the guideline issued in January 2018 clearly aims at facilitating funding and accelerating the implementation of D/E swaps. In fact, it will now be easier for private equity funds to participate and banks will be allowed to reinvest their funding from wealth management products into D/E swaps.

D/E swaps would be great for banks for a very simple reason. Banks can stay out of the picture once the D/E swaps are carried out. And banks retain only 4% of the total amount distributed based on the financial information of the D/E swaps. Most of the proportion is not even being held by banks directly but indeed being disposed through their own asset management companies (AMCs). Our analysis shows AMCs (excluding those set up by banks), insurance companies and state-owned funds are the three most important players, accounting for 34%, 30% and 27% respectively.

However, banks’ limited exposure on the surface looks much bigger when digging into who are the key shareholders of such “state-owned funds”. In fact, 44% of the total registered capital in two of the largest state-owned funds participating in D/E swaps is in the hands of state-owned banks, especially the supposedly low-risk Postal Saving Bank of China, with the rest of shareholders being cash-rich state-owned enterprises (SOEs). This literally means that problem loans are being relabeled outside of the loan book and reallocated both inside and outside the banking system. The difference for banks, though, is massive, as even the part they own through their participation in state-owned funds is not as expensive since it does not consolidate. In other words, the regulatory burden of holding bad assets (both in terms of capital and provisioning) is lifted.

Banks should indeed benefit from the Chinese government’s “matryoshka” approach to the clean-up of banks with D/E swaps. It is a lovely restructuring solution for bank but probably less so for the rest of final investors.

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